Last week, I discussed ISS’s new Equity Plan Scorecard. If you were hoping that the scorecard gave you a free pass on your burn rate, I have some disappointing news. The scorecard doesn’t eliminate the burn rate caps—the caps are a component of a plan’s overall scorecard rating.
The Word “Cap” Is So Limiting
One interesting change I noticed is that ISS is no longer calling them “caps”; now they are “benchmarks.” I’m not sure if this is to make them seem less restrictive or to make companies feel worse about exceeding them because the caps aren’t an arbitrary limit but a benchmark established by their peers.
According to ISS’s FAQ on the Scorecard, a plan gets max points when the company’s burn rate is 50% or less of the benchmark for its industry. The FAQs say that the burn rate score is “scaled,” so I assume this means that partial credit is available if the company’s burn rate is more than 50% of the benchmark but still below it. (If burn rates follow the pattern established in other areas, companies will get half credit if they are in this range. But don’t quote me on that; I didn’t find anything in the FAQs about this–I’m totally guessing). I’m also guessing that if you are over the benchmark, no points for you.
Good News for (Most) Russell 3000 Companies; Not So Good News for S&P 500 Companies
The most significant change is that ISS has broken out S&P 500 companies from other Russell 3000 companies for purposes of determining the burn rate benchmarks. For S&P 500 companies, this results in significantly lower burn rate benchmarks. In a number of industries (energy, commercial & professional services, health care equipment & services, pharmaceuticals & biotechnology, diversified financials, software & services, and telecommunication services), the benchmark dropped more than two points below the cap that S&P 500 companies in these industries were subject to last year.
For most of the Russell 3000 companies that aren’t in the S&P 500, ISS increased the burn rate benchmark slightly. For non-Russell 3000 companies, burn rate benchmarks dropped for the most part (only seven out of 22 industries didn’t see a drop), so I’m guessing that the benchmarks for the Russell 3000 would be lower if the S&P 500 companies hadn’t been removed.
How Does This Play Into the Scorecard?
Burn rate is just one part of one pillar in the scorecard, the grant practices pillar, which is worth 35 points for S&P 500/Russell 3000 companies (25 points for non-Russell 3000 companies). All three types of companies can also earn points in this pillar for the duration of their plan (shorter duration=more points). S&P 500/Russell 3000 companies also earn points in this pillar for specified grant practices. Thus, even if a company completely blows their burn rate benchmark, the plan can still earn partial credit in the grant practices pillar.
In a worst-case scenario, where a plan receives no points at all for grant practices, there’s still hope in the form of the plan cost and plan features pillars. For S&P 500/Russell 3000 companies, plan cost is worth 45 points and the plan features pillar is worth 20 points. That’s a potential 65 points, well over the 53 required to receive a favorable recommendation.
As I noted on October 21 (“ISS Changes Stock Plan Methodology“), ISS is changing how they evaluate stock plan proposals. Just before Christmas, ISS released additional information about their new Equity Plan Scorecard, including an FAQ. For today’s blog entry, I take a look at how the scorecard works.
What the Heck?
Historically, ISS has used a series of tests (Shareholder Value Transfer, burn rates, various plan features) to evaluate stock plan proposals. Many of these tests were deal-breakers. For example, fail the SVT test and ISS would recommend against the plan, regardless of how low your burn rate had been in the past or that fact that all the awards granted to your CEO vest based on performance.
Under the new Equity Plan Scorecard (known as “EPSC,” because what you need in your life right now is another acronym to remember), stock plans earn points in three areas (which ISS refers to as “pillars”): plan cost, grant practices, and plan features. Each pillar is worth a different amount of points, which vary based on how ISS categorizes your company. For example, S&P 500 and Russell 3000 companies can earn 45 points for the plan cost, 35 points for grant practices and 20 points for plan features. Plans need to score 53 points to receive a favorable recommendation. [I’m not sure how ISS came up with 53. Why not 42—the answer to life, the universe, and everything?] So an S&P 500 company could completely fail in the plan cost area and still squeak by with a passing score if the plan got close to 100% in both the grant practices and plan features area.
Plan Cost
Plan cost is our old friend, the SVT analysis but with a new twist. The SVT analysis is performed once with the shares requested, shares currently available under all plans, and awards outstanding, then performed a second time excluding the awards outstanding. Previously, ISS would carve out options that had been outstanding for longer than six years in certain circumstances. With the new SVT calculation that excludes outstanding options, this carve out is no longer necessary (at least, in ISS’s opinion–you might feel differently). The points awarded for the SVT analysis are scaled based on how the company scores against ISS’s benchmarks. Points are awarded for both analyses (with and without options outstanding), but the FAQ doesn’t say how many points you can get for each.
Grant Practices
The grant practices pillar includes our old friend, the burn rate analysis. But gone are the halcyon days when burn rates didn’t really matter because companies that failed the test could just make a burn rate commitment for the future. Now if companies fail the burn rate test, they have to hope they make the points up somewhere else. Burn rate scores are scaled, so partial credit is possible depending on how companies compare to the ISS’s benchmarks. This pillar also gives points for plan duration, which is how long the new share reserve is expected to last (full points for five years or less, no points for more than six years). S&P 500 and Russell 3000 companies can earn further points in this pillar for certain practices, such as clawback provisions, requiring shares to be held after exercise/vest, and making at least one-third of grants to the CEO subject to performance-based vesting).
Plan Features
This seems like the easiest pillar to accrue points in. Either a company/plan has the features specified, in which case the plan receives the full points, or it doesn’t, in which case, no points for you. There are also only four tests:
Not having single-trigger vesting upon a CIC
Not having liberal share counting
Not granting the administrator broad discretionary authority to accelerate vesting
Specifying a minimum vesting period of at least one year
That’s pretty simple. If willing to do all four of those things, S&P 500/Russell 3000 companies have an easy 20 points, non-Russell 3000 companies have an easy 30 points (more than halfway to the requisite 53 points), and IPO/bankruptcy companies have an easy 40 points (75% of the 53 points needed).
Alas, this does mean that companies no longer get a free pass on returning shares withheld for taxes on awards back to the plan. Previously, this practice simply caused the arrangement to be treated as a full value award in the SVT analysis. Since awards were already treated as full value awards in the SVT analysis, it didn’t matter what you did with the shares withheld for taxes. Now you need to be willing to forego full points in the plan features pillar if you want to return those shares to the plan.
Dealbreakers
Lastly, there are a few practices that result in a negative recommendation regardless of how many points the plan accrues under the various pillars. These include a liberal CIC definition, allowing repricing without shareholder approval, and a couple of catch-alls that boil down to essentially anything else that ISS doesn’t like.
I’ve told you to complete the ISS policy surveys in the past and I’m sure a lot of you have scoffed. But this year is different; this year, you might want to think twice about blowing off the survey. ISS has announced that they are considering a significant shift in how they evaluate stock compensation plans. The ISS Policy Survey is your opportunity to give ISS some feedback about how you think they should be analyzing your stock plans.
New ISS Policy on Equity Plans?
According to a recent posting in Tower Watson’s Executive Pay Matters blog (“ISS 2015 Policy Survey — Expanded Focus on Executive Compensation,” July 21), ISS has stated that it is considering using a more “holistic, ‘balanced scorecard’ approach” to evaluate equity plans. The good news is that this might allow for a more flexible analysis, rather than the very rule-based, SVT and burn rate analysis ISS uses today. But, as the Towers Watson blogs points out, it also might result in a less transparent process. Less transparency equates to less confidence in how ISS will come out on your plan when you put it to a vote (and perhaps also more business for ISS’s consulting group).
The 2015 Policy Survey
ISS uses policy surveys to collect opinions from various interested parties as to its governance policies. Corporate issuers are one of the many entities that are encouraged to participate in the survey. This year’s survey includes several questions on equity plans, including what factors should carry the most weight in ISS’s analysis: plan cost and dilution, plan features, or historical grant practices.
There’s a good chance your institutional investors are participating in the survey; don’t you want ISS to also hear your views on how your equity plans should be evaluated?
What Do You Think?
Say-on-Pay and CEO Pay
The survey also includes several questions on CEO pay (that ultimately relate to ISS analysis of Say-on-Pay proposals), including questions on the relationship between goal setting and award values and when CEO pay should warrant concern.
Completing the Survey
You have until August 29 to complete the survey. There may be questions in the survey that you don’t have an opinion on or that aren’t really applicable to you as an issuer–you can skip those questions. But don’t wait to complete the survey, because I’m pretty sure the deadline won’t be extended. On the positive side, however, the survey is a heck of a lot shorter than the NASPP’s Stock Plan Design and Administration Surveys.
ISS has published its burn rate tables for the 2014 proxy season and the news isn’t good. For most industries, the ISS burn rate caps have decreased for 2014. For today’s entry, I have a few fun facts about the new burn rate tables.
For Russell 3000 companies:
Burn rate caps decreased for 14 of the 22 industries in the Russell 3000 that ISS publishes caps for.
Caps increased for seven of the 22 industries (automobiles & components, banks, consumer services, insurance, retailing, semiconductor equipment, and transportation) and the cap stayed the same for the utilities industry.
The largest decrease was for the media industry, which dropped from 5.6% last year to 4.43% for this year (1.17 points). ISS did not decrease the caps for any other industries by more than 1 point.
The largest increase was for the automobiles & components industry, which increased from 3.28% last year to 3.81% this year (.53 points).
For non-Russell 3000 companies:
Burn rate caps decreased for 15 of the 22 non-Russell 3000 industries.
Just as for the Russell 3000 companies, ISS increased the caps for seven industries, but not the same seven. For non-Russell 3000 companies, the industries where the caps were increased are banks, capital goods, commercial & professional services, consumer durables & apparel, insurance, retailing, and technology hardware & equipment.
ISS did not leave the cap the same for any non-Russell 3000 companies.
The largest decrease was 2 points, which is the maximum change (either increase or decrease) ISS allows from one year to the next (yes, ISS puts a cap on the change in the cap).
There were two industries for which burn rates dropped by 2 pts: energy and diversified financials. For energy, the maximum burn rate dropped from 9.46% to 7.46%, but would have dropped to 6.26% without ISS’s cap on changes in maximum burn rates. For diversified financials, the maximum burn rate dropped from 9.56% to 7.56%, but would have dropped to 7.17% without the cap.
For just under half of the industries where the maximum burn rate decreased, the decrease was greater than 1 point. In addition to energy and diversified financials, these industries included automobiles & components, pharmaceuticals & biotechnology, telecommunication services, transportation, and utilities.
The largest increase was in capital goods, which went from 6.69 in 2013 to 8.16 in 2014 (1.47 points).
It’s Like We’ve Got a Good Set of Tarot Cards
For anyone that listened to the NASPP’s November webcast highlighting the results of our 2013 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting), this isn’t a surprise. The survey results foreshadowed this trend. Only 24% of respondents to the survey reported a three-year average burn rate of 2.5% or more (down from 31% in 2010) and, in the past year, almost one-fifth (19%) of respondents took action to reduce their burn rate. The ISS caps are extrapolated directly from actual burn rates (for each industry, the cap is generally the industry’s three-year average burn rate plus one standard deviation); ISS policy in this area simply reflects what is happening in practice.
But there’s one sound That no one knows What do the investors say?
Actually, What Do the Investors Say?
As we are heading into next year’s proxy season (and now that you have that horrible song in your head), I thought it might be a good time to look at what the investor hot buttons are likely to be with respect to executive and stock compensation. I listened to the recording of the session “Say-on-Pay Shareholder Engagement: The Investors Speak” at the 10th Annual Executive Compensation Conference and found a few recurring themes. The panelists were Aeisha Mastagni of CalSTRS, Karla Bos of ING, and Donna Anderson of T.Rowe Price; the panel was moderated by Pat McGurn of ISS.
The investor panelists take a rather dim view of retention grants. They also don’t like programs that grant the same value of stock to execs every year (so that when the stock price drops, execs get more shares).
They weren’t keen on TSR or EPS as performance metrics. They felt EPS is too easily manipulated and too short-term and they would rather see goals that drive TSR, not TSR goals themselves. Which is interesting because TSR and EPS are the two most popular performance metrics in our 2013 Domestic Stock Plan Design survey (co-sponsored by Deloitte).
They didn’t have a lot of use for supplemental proxy filings but opinions were mixed as to the value of realizable pay disclosures.
For next year’s proxy season, the main areas of focus that they generally agreed on were performance awards and metrics, CIC provisions, and employment contracts (e.g., retention bonuses). If you don’t have a good story to tell on those topics, you might want to get cracking.
They all thought the CEO pay-ratio disclosure was of dubious value.
They all also insisted that they were very open-minded about stock and executive compensation and that they don’t blindly follow ISS (it’s just that they happen to agree with ISS on most issues).
Another key takeaway for me was that all of the investors explained that they focus on “the outliers” when reviewing proxy statements. They have lots of proxies to review and can’t do an in-depth analysis of each one. But if something about your executive pay grabs their attention because it is outside the norm, they will look closer at your company. So make like a junior high student and try to blend in.
There aren’t any surprises, at least when it comes to executive and stock compensation. ISS didn’t make any changes specific to stock compensation and the only change that relates to executive compensation is that they’ve changed the Relative Degree of Alignment measure to be a three-year calculation only, rather than a weighted average of the one and three-year calculations.
Six Degrees of Kevin Bacon
The Relative Degree of Alignment measure doesn’t have anything to do with Kevin Bacon (although it might be argued that it would be a lot more interesting if it did). Instead, as I noted in my blog on ISS’s proposed changes (“ISS Policy Changes for 2014,” October 29, 2013), it simply compares the company’s TSR ranking among its peers to its CEO pay ranking. Ideally (from ISS’s perspective, that is–your CEO might feel differently), your company will have a high TSR ranking and a CEO pay ranking that is equal to or lower than its TSR ranking. A low TSR ranking and a high CEO pay ranking will result a negative RDA and probably a lot more attention from ISS than you’d like.
What’s Changed
The old calculation averaged the one-year RDA and the three-year RDA with a respective weighting of 40/60. The new calculation is just the three-year RDA.
Why Change?
Because the most recent year was included in both the one-year and three-year calculations, the prior RDA measure placed significant emphasis on this year. By eliminating the one-year RDA measure, the most recent year will be deemphasized in favor of the longer three-year period. As a result, short-term changes in TSR and CEO pay rankings will have a smaller impact on this aspect of ISS’s analysis. ISS also notes that the longer term calculation will help alleviate timing mismatches in pay for performance that result from equity awards being issued early in the fiscal year, before the corresponding performance year.
No Burn Rates Yet
The burn rate tables aren’t available yet. I expect them some time in mid to late December. Hmmm, maybe I’ll be able to get three blog entries out of this whole policy update.
Don’t Miss Your Chance to Update Your Peer Group with ISS
The companies that ISS considers to be your peers are critical for the RDA measure as well as numerous other analyses that ISS performs. ISS will consider your self-selected peers when constructing your peer group. You have until December 9 to let ISS know which companies are in your self-selected peer group. For more information see, ISS’s Peer Group Methodology FAQ. You can submit your peers and any other feedback you have for ISS on your peer group at http://www.issgovernance.com/PeerFeedbackUS.
ISS has proposed changes to its corporate governance policy for 2014. You have until November 4 to comment on the changes.
What’s Changed?
In terms of stock compensation, or even compensation in general, not much. So the good news is this maybe isn’t something you have to spend a lot of time on this year and I can have a short blog entry today. Of course that’s also the bad news–things aren’t going to get any better next year in terms of the restrictions ISS places on your stock compensation program.
Evaluating Alignment of Pay to Performance
The only proposal that relates directly to compensation that ISS is looking at changing is the Relative Degree of Alignment (RDA) measure, which compares the difference between a company’s TSR ranking and its CEO’s pay ranking among its peers. For example, if the company’s TSR ranks in the 25th percentile among its peers (meaning that the company’s TSR is better than only 25% of its peers) and its CEO’s pay is in the 75th percentile (i.e., the CEO’s pay is more than 75% of his/her peers), ISS might be concerned that there is a pay for performance misalignment. This is just one of several measures ISS uses to assess whether CEO pay aligns with company performance.
Currently ISS calculates RDA on a one-year and three-year basis. They are proposing to eliminate the one-year calculation and instead consider only three-year RDA. If your RDA score has been trending downwards, you are probably pleased as punch about this; if your RDA score has been trending upwards, you are probably a little less thrilled (but what goes up most come down and, under the proposed calculation, if you do have a down year, that year won’t impact your RDA score as much).
This week I have a couple of additional treats from the smorgasbord of topics related to stock compensation. Enjoy!
FAQs on ISS Peer Groups I guess I wasn’t the only one confused by ISS’s new peer group methodology; ISS has issued an FAQ to explain the new process.
There’s still a bunch of stuff about 8-digit, 6-digit, 4-digit, and 2-digit GICS codes that I don’t understand, but the gist that I came away with is that peers are selected first from within the company’s 8-digit code. ISS constrains which companies can be considered peers based on size (by revenue and market capitalization), so if there aren’t any 8-digit peers that fit within those constraints, then ISS moves to the 6-digit peers, and then to the four-digit peers. ISS will not select peers that match only based on the 2-digit code.
I finally googled “GICS Codes” to figure out what all these digits mean. Standard & Poor’s assigns companies to ten 2-digit industry groups (your 2-digit GICS code). Then within that 2-digit code, you are assigned to a more specific 4-digit code, and within that 4-digit code…all the way down to the 8-digit code. So the companies that share your 8-digit code should be those that most closely resemble you in terms of industry classification.
When selecting among those peers that meet your size constraints, ISS will give priority to companies that are in your self-selected peer group or that have been selected you as a peer, as well as companies that have been selected as peers by your peers or that have selected by your peers as their peers. This sort of feels like that game “Six Degrees of Kevin Bacon.” Note that if you’ve changed the companies in your self-selected peer group since last year, ISS has provided a special form that you can use to notify them of the change; you have until Dec 21 to do so.
What does all of this have to do with stock compensation you ask? Well, not much, because these peers have nothing to do with the burn rate tables published by ISS (those are based solely on 4-digit GICS codes). ISS uses these peer groups only for purposes of determining whether compensation paid to your CEO aligns with company performance. But it’s good to be aware of your ISS peer group because it probably differs from the peers you’ve identified for purposes of your performance awards and other LTI programs. Thus, even though your CEO has awards that vest based on performance, ISS could still find that his/her pay doesn’t align with company performance.
Top Ten Myths on Say-on-Pay A group of academics from Stanford and the University of Navarra have written a paper to debunk myths related to Say-on-Pay. Beside being an interesting topic, the paper has the advantages of being short (only 14 pages, including exhibits) and is written in fairly straightforward English (the word “sunspot” doesn’t appear in it anywhere).
My favorite myth is #6: “Plain-vanilla equity awards are not performance-based.”
Both ISS and Glass-Lewis have published updated corporate governance guidelines for the 2013 proxy season. The good news for my readers is that, in both cases, there aren’t a lot of changes in the policies specific to stock compensation; I think that Say-on-Pay is a much hotter issue for the proxy advisors right now than your stock compensation plan. Here is a quick summary of what’s changed with respect to stock compensation.
I don’t think ISS made any changes that directly apply to stock compensation, but there were some changes in their general policies on executive and CEO pay that may have an impact on your stock program:
Peer Groups: ISS assigns each company to a peer group for purposes of identifying pay-for-performance misalignments in CEO pay. The determination of company peer groups has been an ongoing source of much consternation; many companies disagree with the peers ISS assigns. In the past, peers have been determined based on GICS codes, market capitalization, and revenue. The new policy involves a lot of technical mumbo jumbo about 8-digit and 2-digit CICS groups that I don’t understand, but the gist that I came away with is that companies’ self-selected peers will somehow be considered in constructing peer groups. I’m not convinced this will be the panacea companies are looking for, but hopefully it will be an improvement.
Realizable Pay: Where ISS identifies a quantitative misalignment in pay-for-performance, a number of qualitative measures are taken into consideration before ISS finalizes a recommendation with respect to the company’s Say-on-Pay proposal. Under the 2013 policy, for large cap companies, these measures will include a comparison of realizable pay to grant date pay. For stock awards, realizable pay includes the value of awards earned during a specified performance period, plus the value as of the end of the period for unearned awards. Values of options and SARs will be based on the Black-Scholes value computed as of the performance period. If you work for a large-cap company, you should probably get ready to start figuring out this number.
Pledging and Hedging: Significant pledging and any amount of hedging of stock/awards by officers is considered a problematic pay practice that may result in a recommendation against directors. My guess, based on data the NASPP and others have collected, is that most of you don’t allow executives to pledge or hedge company stock. But if this is something your company allows, you may want to get an handle on the amounts of stock executives have pledged and consider reining in hedging altogether.
Say-on-Parachute Payments: When making recommendations on Say-for-Parachute Payment proposals, ISS will now focus on existing CIC arrangements with officers in addition to new or extended arrangements and will place further scrutiny on multiple legacy features that are considered problematic in CIC agreements. If you still have options or awards with single-trigger vesting acceleration upon a CIC (and, based on the NASPP and Deloitte 2010 Stock Plan Design Survey, many of you do), those may be a problem if you ever need to conduct a Say-on-Parachute Payments vote.
Glass Lewis Updates
Glass Lewis, in their tradition of providing as little information as possible, published their 2013 policy without noting what changed. I don’t have a copy of their 2012 policy, so I couldn’t compare the two but I’ve read reports from third-parties that highlight the changes.
As far as I can tell, the only change in their stock plan policy is that Glass Lewis will now be on the lookout for plans with a fungible share reserve where options and SARs count as less than one share (the idea is that full value awards count as one share, so options/SARs count as less than a share). It’s a clever idea for making your share reserve last as long as possible, but, to my knowledge, these plans are very rare (I’ve never seen one even in captivity, much less in the wild), so I suspect this isn’t a concern for most of you.
While normally ISS’ annual release of policy updates is a relatively exciting, blog-worthy event, this year’s release feels anti-climatic (at least with respect to their compensation policy–maybe there’s some really hot updates to their policies on, say, hydraulic fracturing and recycling–I wouldn’t know) because they previewed the changes several weeks ago (see my Nov 15 blog, “ISS Previews Policy Changes“).
As far as I can tell, the final policy doesn’t really differ much from the proposed policy. In fact, given the short comment period on the proposal and the quickness with which the final policy was released, I have to wonder if they received many, if any, comments and if they did much with the comments. Unlike the IRS, FASB, and the SEC, ISS doesn’t publish/summarize the comments they received or address how those comments were taken into consideration.
Policy Changes for Stock Compensation
As summarized in my previous blog, really the only policy change that directly impacts stock compensation is that when newly public companies first submit a stock plan for shareholder approval for Section 162(m) purposes, ISS will now conduct a full review of the plan. In the past, they basically rubber-stamped these proposals.
This might be big news for LinkedIn, Yelp, Groupon, Zynga, and other recent and anticipated IPOs (and their compensation consultants), but for most of my readers, who have been public for a while now, this isn’t that groundbreaking.
Pay-for-Performance
The changes with regards to how ISS evaluates pay for performance also seem to have been adopted largely as proposed. ISS will now determine peer groups based on market capitalization, revenue, and GICS codes, rather than just relying on GICS codes. This could make it difficult for companies to determine who is in their ISS peer group on their own, thus making it hard for companies to predict how they’ll compare against their peers.
ISS will compare a company’s TSR and CEO pay rankings in the peer group and the CEO’s total pay relative the peer group median. Where merited, ISS will also perform a qualitative analysis. This will include a number of factors, the most interesting of which to me is that ISS will look at the ratio of performance to time-based equity awards (I assume this is limited to awards issued to the CEO, but this isn’t completely clear to me from ISS’ summary of the updates). As my readers know, there were several companies this year that modified time-based awards held by their CEO’s to vest based on performance conditions (see my May 3 blog, “Eleven and Counting“). I have to believe these two developments are connected and we can expect ISS to push for more performance-based vesting–at least for CEOs–in the future.
Burn Rates
The updated burn rate tables are not included in the summary of the changes–last year ISS didn’t release these until mid-December so I guess that’s when we’ll get them this year. Is it just me, or does it seem like ISS is releasing these tables later and later?
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.